Intellectual Myopia On Insider Trading

Richard Epstein*

Richard Epstein

Richard Epstein

This past week, the United States Supreme Court heard oral argument in Salman v. United States, an important case concerning federal securities law. At issue are the limitations placed on insiders who trade in the shares of companies on the basis of material, nonpublic information. The parties covered are not only those who obtain the information themselves, but the persons to whom they (as “tippers”) pass on that information, commonly called tippees.

The prohibition on insider trading is said to derive from Section 10(b) of the Securities Exchange Act of 1934, which makes it unlawful for any person to “employ any device, scheme, or artifice, to defraud,” as implemented under SEC Rule 10b-5.  The purpose of this prohibition on insider trading is to restore overall investor confidence in the exchange markets, by denying to certain insiders the ability to reap undue benefit because of the informational advantage from undisclosed information that they gain against their actual or potential trading partners.

The extension of Rule 10b-5 to insider trading only took place in 1962 in the critical SEC decision In Re Cady, Roberts, & Co., and it has been long surrounded by controversy. Salman concerns whether, under Rule 10b-5, the tipper of the inside information had to receive some tangible benefit from the tippee, or whether some more diffuse social benefit sufficed to trigger criminal liability. 

The simple fact that the SEC sought to expand the scope of the insider trading prohibition has generated serious uneasiness. In writing about this case in Defining Ideas, Professor Jonathan Macey, a noted securities law expert at the Yale Law School, reaches the grim conclusion that Salman could easily provide the government with an opportunity to unduly expand the reach of the securities law by allowing it to use its own ill-defined notions of “fairness” to attack just about anyone it wants. In the abstract, that point resonates with small-government groups, such as the Cato Institute, whose amicus brief for Salman stresses an argument Salman’s lawyer, Alexandra Shapiro, made in court—that what qualifies as criminal should be narrowly construed in order to avoid dangerous government overreach.

In general, I am no defender of increasing the breadth of government enforcement. But in Salman these fears are wildly overblown. In this instance, liability should be expanded to cover all individuals who make unauthorized use of insider information whether or not the tipper has received any benefit from the tippee.  To see whether this rule makes sense, let’s start with the facts of the case. Maher Kara, who worked in Citigroup’s healthcare investment banking group, passed along inside information to his older brother, Michael Kara, who knew that the information was stolen but nonetheless used it to make some advantageous trades. Michael then shared the information with his future brother-in-law, Bassam Salman, who then followed Michael’s trades.  Salman, like Michael, knew that he was trading on stolen information. At this point, it is instructive to analogize the situation to one in which Maher took some tangible property from Citigroup, which he then gave to Michael, who then transferred some portion of his booty to Salman, who then used or disposed of it for his own personal benefit. In these cases, the standard common law rule is that Citibank could recover any profits Salman got from the use or sale of the stolen property.

As I explained in a recent article in the Yale Law Journal, the applicable principle for dealing with stolen tangible property—and by extension stolen information—is that the only person with any valid claim to the property is the bona fide purchaser for value. Raising that defense bars two types of individuals from keeping the property. The first are those who bought the property with knowledge that it was stolen. The second are those who received it as a gift from the thief. When the theft is established, the law imposes a constructive trust on the donee, which in turn requires him to return the stolen property, or the proceeds of its sale, to the owner. The word “constructive” means that the recipient is treated as if he had received the property as a trustee, even though he did not.

The same basic framework carries over to the theft of information, such that Salman flunks both ways. He received the stolen information as a gift, and he knew that it was stolen. He is the lowest of the low, a bad faith donee. So why then does his pathetic case end up in the Supreme Court? Because the Justices have for years asked the wrong question, assuming that Maher and Michael had to receive in return some “personal benefit” from Salman for his use of the stolen information. More precisely, the question presented was:

Whether the personal benefit to the insider [Maher] that is necessary to establish insider trading under Dirks v. SEC requires proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the Second Circuit held in United States v. Newman, or whether it is enough that the insider and the tippee shared a close family relationship, as the Ninth Circuit held in this case.

The question presents a false choice, when the right answer is that no return benefit should be required at all, once Salman knew that he was trading on stolen information. Instead, the constructive trust should be imposed to capture his knowingly illegal conduct. The only interesting question is how the Supreme Court persuaded itself that some return benefit was required in insider trading cases. At this point, we need to unpack the two cases mentioned in the question presented.

First, take Dirks. Raymond Dirks was an officer of a broker-dealer of a corporation who received from Ronald Secrist, a former officer of Equity Funding, reliable information that Equity had deliberately inflated its share values. Dirks freely shared this information with clients and investors, who sold their stock to avert future losses, when he could not persuade either the SEC or the Wall Street Journal to investigate based on his tips. The legal question was whether Dirks, who surely operated from mixed motives, was guilty of aiding and abetting insider trading—and no more, since he did not trade himself. The answer given by the ever-prudent Lewis Powell was that he was not. He was not an insider and hence he could only be held responsible “when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee [here Salman, once removed] and the tippee knows or should know that there has been a breach.” Justice Powell then introduced the personal benefit test into the equation by noting that the question of whether the insider was in breach of his fiduciary duty depends “in large part on the personal benefit that the insider receives as a result of the disclosure.”

At this junction, the dispute under the personal benefit test is whether tangible benefits are required, as suggested in Newman, or whether a set of close family interconnections, such as those found in Salman, suffices.

This entire learned debate is an irrelevant diversion. The simple point here was that Dirks knew that this was inside information, and so the key question is what should he do with that information in order to expose a scandal. The simple answer is that he should make that information public before sharing it with his various clients, but his failure to do so makes him guilty of abetting the insider trading, which is what the lower court found. And that is surely the case in the ordinary situation where the tippee receives information about inside share value that he shares with his customers when there is no whiff of scandal at all. In neither case is there any room for an actual fiduciary duty of the sort that corporate officers and directors owe to a firm. It is enough to impose the constructive trust by analogy to the physical transfer.

This view of the transaction helps explain the correct resolution of the situation presented in Newman, on wholly different facts. In that case, officers of two corporations released information to a selected group of analysts at the behest of the company in order to stimulate interest in the firm’s shares in ways that would increase their value. Unfortunately, the SEC promulgated Regulation FD. (i.e. fair disclosure) in 2000, making it unlawful to release company information selectively to some analysts unless, in the name of “full and fair” disclosure, it released the information to all. As usual, the SEC missed the mark. So long as the world is on notice that these selective disclosures are made, all traders can take that into account in making their own decisions for those firms (which need not be all firms) that engage in the practice. There is accordingly no fraud.

As it happens, Regulation FD imposes sufficient dislocation on firms that management tends to authorize,sub rosa, just these selective disclosures on the theory announced above—that inside information can be used by all recipients for their purposes, so the taint on all transferees is removed. Sadly, that line of argument was not open to the Court in Newman, so it then decided the case on two related grounds. First, the remote tippees (three and four links away) received this information as part of a deluge of information from multiple sources that made it impossible for them to know whether they had inside information or not—a problem completely absent in Salman. Second, the Second Circuit held that the diffuse set of personal benefits linking the various parties together—all of which were weaker than the close family ties in Salman—flunked the personal benefit test as announced in Dirks, setting up the conflict between the circuits when the Ninth Circuit in Salman held that the family connections sufficed.

During the oral argument before the Supreme Court, the Justices and the lawyers inconclusively bandied about endless hypotheticals as to what counts as a personal benefit. But as is so often the case, no one bothered to rethink the relevance of that issue at all. The correct resolution involves knocking out Regulation FD, and asking whether the release of the information was authorized expressly or implicitly by the firm—and if not, whether the tippee knew of its illegal release. In this scenario, the personal benefit test becomes irrelevant and Salman gets the hard punishment he deserves.

It is sometimes said, as by Professor Macey, that this view of liability opens the floodgates on insider information, but it does nothing of the sort. In United States v. O’Hagan, a 1997 Supreme Court decision fleetingly mentioned by the Court in the oral argument for Salman but extensively discussed by Macey, the defendant was the lawyer for a large firm, MetLife, who took confidential information that he received from MetLife, which he then used to buy shares on his own account, thus running up the price that MetLife had to pay to complete the operation. This situation is an open-and-shut breach of the standard agreements always imposed by law firms and investment banks on their members—never to trade against the interests of a client. Clearly, that decision retains its full force no matter which way Salman comes out because of the enormity of the self-dealing. But should the case have come out differently if James O’Hagan had given key information to a casual friend who did the same thing? The danger to the client interest is the same whether the insider uses the information alone or shares it with a friend.

If you think of the securities law as trying to reinforce the restrictions that private parties impose on their employees and independent contractors, then Salman has to be decided for the SEC to prevent wholesale breaches of insider’s fiduciary and contractual duties—but only if the Supreme Court shakes off its intellectual myopia and rethinks the question as a matter of first principle.

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.